Is It Time to End Limited Liability for Corporate Shareholders?

From time to time people ask me how environmental depredations would be contained in a libertarian world order. They are concerned that libertarians would be unable to address the devastation wrought by companies engaging in, by way of example, mountaintop removal.

The obvious answer is that the EPA and federal and state regulators have not prevented mountaintop removal. They have often been unable/unwilling to stop companies from wreaking other environmental havoc. Instead, they have been taken over by the industries the agencies seek to regulate. I should also mention that the EPA has itself been the cause of environmental contamination. Consider, for example, that the EPA contaminated the Animus River in Durango, CO while attempting to remediate contaminated water from the Gold King Mine. Prior to that event, EPA contractors in Greensboro, Georgia struck a water main causing sediment, containing arsenic, mercury, lead and chromium to flow into the Oconee River.

That the state has not been able to contain the damages wrought by certain companies is not a sufficient answer to the question of how such damages would be dealt with in a libertarian world. Environmental contamination/degradation is a real problem and to point out that the government hasn’t solved the problem and that it is sometimes a major contributor does not answer that question. So what would happen in a libertarian world order?

In a truly anarcho-capitalist world, the limited liability of the shareholders of corporations would be abolished. In a libertarian world order, owners of companies would not be able to garner the special state-created privilege of limited liability for the consequences of corporate acts. If companies engaged in highly risky behavior (e.g. drilling for oil in the Gulf), the owners would be personally liable for the costs of any oil spills.

Stunning, huh? It seems so outrageous as to be inconceivable, but there’s no reason that it shouldn’t be conceived and every reason to think it ought to be thought of.

The material in this and the next paragraph is drawn from Limited Liability in Historical Perspectiveby Frederick G. Kimpin, Jr. published in American Business Law Association Journal. If we review the history of corporate entities, we learn that corporations arose when the need to amass capital exceeded the capacity of any single person. Corporate charters have always been granted by the state (or the monarch in earlier times); however, limiting the liability of shareholders was not an essential element of the corporate charter. Corporate forms were sought because corporate charters allowed unrelated parties to easily amass large amounts of capital; they often conferred monopoly privileges on the owners; and, the owners had the right to freely transfer their ownership interests.

Most frequently laws in the American states grew out of English law; however, corporate law developed in the United States influenced the development of English law. In both England and America, industrialization was seen as socially beneficial. State legislatures believed that the public would benefit from rapid industrialization. It was the thesis of those wishing to promote rapid industrialization that entities would be able to more rapidly amass large capital sums if the liability of the owners was limited. Beginning in roughly 1830, industrialists were able to convince state legislators that limited liability of shareholders was essential to their burgeoning enterprises and also to prevent the flight of capital from one state to another.

Once again, we see how a state, by attempting to legislatively solve a problem best left to the market participants, created a new problem that influences us today in ways unimagined by the creators of the law.

Prior to states creating corporate entities with limited liability, all owners were personally liable for the consequences of their business enterprises. If a manufacturer dumped his coal ash on his neighbor’s property, that was a trespass and the dumper was liable for damages. Once real people who were owners were immunized from personal liability, it was more difficult to attach liability to the bad acting corporate owner. If the corporate owner dumped his coal ash in the local stream, it was not legally immune from the act, but its shareholders were. Instead of dealing with a single bad actor likely on the same financial footing as himself, the injured party had to sue the well capitalized corporate entity and to sue it in a court which was not inclined to view his suit favorably when the industry was employing so many people and providing so many new products to others.

If shareholders were no longer immune from liability for corporate acts and corporate debt, undoubtedly the impact would be huge. First of all, each company would be highly motivated to create very safe business operations. Secondly, “owners” in name only would disappear. Who would want to own part of an enterprise that exposed them to personal liability when they had no control over the business operations? Would we have seen a day where a corporation bought its own stock with borrowed funds? Such an act would substantially increase the liability of the remaining shareholders. No sensible owner would agree to substantially increase his own personal liability for no additional benefit to himself or the business enterprise, i.e. the leveraged buyback of stock through the issuance of corporate bonds, which has contributed to the current rise in stock market prices, would never have happened.

We have a much more recent example of the cost of shifting liability from real people to remote owners if we look at what has happened with Wall Street over the last thirty (30) years. Prior to thirty (30) years ago, the investment banks on Wall Street were run as partnerships, not as corporations. That is, the partners in the investment banks were personally liable for the obligations of the investment banks. As Michael Lewis was quoted in AEI:

John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation…. he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders.

But it made fantastic sense for the investment bankers. From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government [aka the U.S. taxpayer, see comments]. “It’s laissez–faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

In his remark that investment banking is laissez-faire “until you get in deep shit,” Gutfreund is saying what we all know to be true. The gambling losses on Wall Street are backed by the full faith and credit of the United States taxpaying public. So, today, the government has compounded the recklessness of Wall Street. Not only are the investment bankers not personally liable as they were when they were partners, but even the potential losses of shareholders have been backstopped by the US Treasury. In theory, shareholders could share in the losses the banks created, but even that possibility is forestalled by the backstop from the US government. Surely, we can see the devastating effects of removing personal liability from actors if we consider the actions of the Wall Street bankers over the last few decades.

In The Righteous Mind, Why Good People are Divided By Politics and Religion, Jonathan Haidt imagines that a powerful central government can limit the damages caused by corporations. He imagines that the evil of regulatory capture can be avoided. He imagines that rules can contain the damages done by entities in which, ultimately, no one is personally responsible. There is no evidence that is so and all the evidence is to the contrary. As was noted in an earlier post, at the time of the financial crisis, there were 115 agencies regulating the financial sector. Would one more agency have made a difference? Between 2014 and 2015, the economy grew only 2.6%, but the federal outlay for business regulation grew by 4.2%. If those new regulations do nothing else, they do increase the cost of starting a new business.

We need to ask ourselves if layering on additional regulations will solve problems or only create new problems? At what point does the cost of complying with new regulations outweigh any potential benefit to be achieved? There is little evidence that the state has, by creating new laws, undone the damage it did by enacting earlier laws. It may be time to return to first principles and allow humans to be held responsible for the consequences of their acts. Let’s begin to discuss phasing out shareholder’s immunity for corporate acts.

I am a person embarking in a new direction after 30 years practicing commercial law. I am a late-comer to Libertarianism, but like most people, once my eyes were opened to the criminality of the state, I could not close them again. I would like to engage more women with Libertarian ideals, but most of my friends are progressives. Some are out and out Hillary supporters.